TRADING REALITIES THE TRUTH, THE LIES, AND THE HYPE IN-BETWEEN J E F F A U G E N

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2 TRADING REALITIES THE TRUTH, THE LIES, AND THE HYPE IN-BETWEEN J E F F A U G E N

3 Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jim Boyd Editorial Assistant: Pamela Boland Development Editor: Russ Hall Operations Manager: Gina Kanouse Senior Marketing Manager: Julie Phifer Publicity Manager: Laura Czaja Assistant Marketing Manager: Megan Colvin Cover Designer: Chuti Prasertsith Managing Editor: Kristy Hart Project Editor: Betsy Harris Copy Editors: Apostrophe Editing Services and Krista Hansing Editorial Services, Inc. Proofreader: Kathy Ruiz Indexer: Joy Dean Lee Compositor: TnT Design Manufacturing Buyer: Dan Uhrig 2011 by Pearson Education, Inc. Publishing as FT Press Upper Saddle River, New Jersey This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services or advice by publishing this book. Each individual situation is unique. Thus, if legal or financial advice or other expert assistance is required in a specific situation, the services of a competent professional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly from the use or application of any of the contents of this book. FT Press offers excellent discounts on this book when ordered in quantity for bulk purchases or special sales. For more information, please contact U.S. Corporate and Government Sales, , corpsales@pearsontechgroup.com. For sales outside the U.S., please contact International Sales at international@pearson.com. Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners. All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher. Printed in the United States of America First Printing October 2010 ISBN-10: ISBN-13: Pearson Education LTD. Pearson Education Australia PTY, Limited. Pearson Education Singapore, Pte. Ltd. Pearson Education Asia, Ltd. Pearson Education Canada, Ltd. Pearson Educatión de Mexico, S.A. de C.V. Pearson Education Japan Pearson Education Malaysia, Pte. Ltd. Library of Congress Cataloging-in-Publication Data Augen, Jeffrey Trading realities : the truth, the lies, and the hype in- between / Jeff Augen. p. cm. ISBN (hbk. : alk. paper) 1. Investments. 2. Speculation. 3. Capital market. I. Title. HG4521.A dc

4 To Takahashi Sensei who represents the very best of everything focus, discipline, hard work, and unending dedication to achieving perfection.

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6 Contents Preface...xiii First Principles...1 Chapter 1: Global Economic Forces and the Average Investor...5 Trade Imbalances, Fiscal Policy, and the Average Investor...5 Strong Dollar, Weak Stock Market...9 Chapter 2: The Harsh Realities of the Marketplace...23 Identifying Critical Information...23 Meaningful Insights and Unique Views...25 Swimming Upstream...29 The Long Term Fallacy...34 The Fallacy of Paper Losses...36 Don t Buy the Dips...36 Misconceptions about Risk...38 The Perils of Earning Interest...41 Chapter 3: Betting with the House...49 Better Than Forecast...49 Intentionally Misleading...56 Bet with the House...59

7 vi Trading Realities Chapter 4: Identifying Trends...63 Highly Efficient Markets...63 The Technical Charting Fallacy...66 Decorating the Chart...69 Predicting Reversals...82 Identifying a Financial Bubble...84 Exaggerations in the Financial News...92 Waiting for Confirmation...96 Spotting a Major Reset...98 An Ongoing Catastrophe as a Trend Summary Chapter 5: A New Era Introduction Relevant History for a New Era Other Recent Corrections Cause Versus Symptom Characteristics of the New Era Problems with Technical Analysis in the Modern Era Summary Chapter 6: The Importance of Volatility Introduction Fooled by Randomness Studying Price Change Behavior Calculating Volatility The CBOE Volatility Index...168

8 Contents vii A New Indicator for Predicting Market Corrections Trading Volatility Chapter 7: Strategies for a New Market The Most Common Mistake A Few Simple Dynamics Diversification Versus Hedging Collars Vertical Bull Spreads Covered Calls Weekly Options An Unprecedented Opportunity Selling At-the-Money Puts Synthetic Stock Deep In-the-Money Puts and Calls Stock Replacement Summary Evolving Strategies Appendix A: Options Primer Black-Scholes Pricing Model Calls and Puts Implied Versus Historical Volatility Skewed Volatility The Volatility Smile Term Structure The Greeks Summary Index...251

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10 Preface Most investors who buy a stock believe that they are investing in a company. That view, while technically correct, is also misleading. A stock investment is really nothing more than a bet on the direction that money will take as it flows through the financial markets. A stock can rise only if market forces align to aggressively drive up the bid price causing new money to flow into the stock. Many different factors are involved including economic news, announcements from other companies in the same industry, political events, the actions of large institutional investors, analysts forecasts, and a variety of global economic forces such as changes to currency exchange rates and interest rates. The long-term performance of a stock represents nothing more than the compounded effect of these forces over time. It is also important to recognize that the financial markets are a zero sum game with competition at all levels. The stock market competes for money against the bond and currency markets; industries compete for money with each other; and money flows between stocks within a particular industry. An individual stock can fall because money is flowing into the bond market. It can also fall because money is flowing into another stock in the same industry. Conversely, the stock of a poorly performing company can rise if market forces are properly aligned. All factors considered, the price of

11 xiv Trading Realities a stock is often only loosely connected to the performance of the underlying company. There was a time, not long ago, when individual investors were the dominant force in the market. Buying a stock was equivalent to betting on the behavior of the other market participants. Those days have passed. Today s markets react to economic news in a fraction of a second, with computer algorithms driving most of the behavior. Heavily traded stocks in the S&P 100 or Dow rise and fall for reasons that are nearly impossible to understand at the individual stock level. Investors who recognize these complex dynamics can gain an advantage because they have a balanced, realistic view of the problem. They spend most of their time identifying the underlying forces driving the markets, and they always try to invest with those forces instead of against them. In this regard, the most important attribute an investor can have is humbleness because successful investing is a never-ending struggle. The goal of this book is to make that struggle easier.

12 First Principles This book is designed to help investors understand the economic and political forces that drive financial markets and to invest alongside those forces instead of against them. It also provides a blunt assessment of the limitations that most private investors face. Understanding these limitations and being able to manage risk are as important as choosing the right investments. The following basic principles are central to the theme of this book: Financial markets, and stock markets in particular, always move in the direction that will do the most damage to the most investors. There are valid mathematical reasons underlying this assertion. In the most basic terms, when a large number of investors are on one side of the market and the market moves against them, the short-term losses create a wave of activity that becomes self-reinforcing. It is for this very reason that high-volume days with the most aggressive buying tend to occur just before sharp corrections. 1

13 2 Trading Realities Financial markets are interrelated. Understanding the effects of one market on another is critical to successful investing. Nobody should ever invest in a market that doesn t make sense to them. In this regard, it is critical to be able to rationalize moves of the market with changes in the economy and financial news. Individual stocks tend to be swept along by the market. Even the best companies suffer declines during a market correction, and the worst companies can rally in a strong bull market. The gap between market and individual stock performance is not always obvious. Many investors blame the market when their stocks decline and credit themselves with wise investing when the same stocks rise. They never take the opposite view that is, they never believe that they re lucky when they make money and that their losses are due to bad investment decisions. Taking a more pessimistic view will make you a better investor. It will drive you to work harder and be more diligent. Blame yourself, not the market, for losses. Experienced investors tend to overrate their knowledge about the companies they invest in. Gaining insights not already known to the market is a very difficult undertaking. Quarterly reports and analyst reviews cannot fill the gap. If you can t describe a company in terms of its revenue streams, sales pipelines, distribution channels, product roadmaps, and business models, then you don t understand the

14 First Principles 3 company well enough to become a shareholder. Recognize that buying shares of stock is equivalent to purchasing a minority stake in a company. Don t invest in a company that you wouldn t feel comfortable owning, and if you can t gain that level of comfort then don t invest. The ability to interpret and understand government reports and news releases is a critical skill. These reports contain a wealth of information buried at a level of detail that most investors try to avoid. It is a mistake to let the financial news media interpret this information for you. Complexity and detail are your friends because they allow you to gain an advantage over the market and lazy investors who are unwilling to do their own homework. Understanding and avoiding risk is a key component of basic investing. Understand the relative risks of different financial instruments and avoid overusing leverage. Don t be fooled into believing that interest-earning investments are automatically safe. The most dangerous three words in the investment world are can t possibly happen. These concepts will weigh heavily in our discussions. However, they are not intended as simple guidelines and, on their own, they cannot be used to choose profitable trades. They are intended as background themes that can be used to guide your thinking.

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16 I N D E X A ABACUS 2007-AC1, 30, 32 ACA Management, LLC, 30 Afghanistan and Iraq wars, 6 aggressiveness in buyers/sellers, AIG (American International Group), CDS (credit default swaps), 121 Alcoa Aluminum, 76, 82 Amazon implied versus historical volatility, July-August 2010, , 185, 197 news relevancy Barnes & Noble announcements, Kindle ereader, 181 put and call options, 197 American International Group (AIG), CDS (credit default swaps), 121 anti-dilution clauses, 24 AOL, 127 Apple Computer chance of single tick price change for 60,000 ticks, minutes after uptrend of minutes #1 and #2, minutes repeating previous minute s direction, recognition of powerful forces, 222 switch from IBM to Intel processors, 26 weekly stock options, Asian financial crisis, July 1997, 134 at-the-money puts or calls, skewed volatility or volatility smile, 238 B Balance of Trade, 49 Bank of America, 77 Barnes & Noble, news relevant to Amazon, Bernanke, Ben, 8-9, 11, 87 better than forecast, 49 Black-Scholes pricing model, Greeks, , 246 Black, Fischer,

17 252 Index BLS (Bureau of Labor Statistics) CPI (Consumer Price Index), 49 misleading reports, Employment Situation Report, adjustments, importance of, inaccuracies, 51 bonds, earning interest risks, BP (British Petroleum), catastrophes as trends, Bureau of Labor Statistics (BLS) CPI (Consumer Price Index), 49 misleading reports, Employment Situation Report, adjustments, importance of, inaccuracies, 51 buyer aggressiveness, buying the dips, C calculating volatility, calls and puts, Amazon, July-August 2010, 197 cash-covered, 230 implied versus historical volatility, short at-the-money puts, cash-covered calls and puts, 230 CBOE Futures Exchange (CFE), 219 CBOE S&P 500 Three-Month Variance Futures, 219 CBOE S&P 500 VARB-XTM Strategy Benchmark, 220 CDS (credit default swaps), 121 charts catastrophes as trends, fallacies, in predictions, major resets, news-annotated, 157 news items of relevancy, 69 Amazon and Barnes & Noble, Amazon s Kindle ereader, 181 caution before actions, exaggerations, financial bubbles, oil trading, reversal predictions, U.S. Steel, Chicago Board Options Exchange Volatility Index. See VIX China, as financial power, 129 Cisco, 127 Citigroup, 101 collars, 38-41, Compaq, 127 Consumer Price Index (CPI), 49 misleading reports, versus long stock positions, 38 Consumer Sentiment Indexes, 49 covered calls, CPI (Consumer Price Index), 49 misleading reports, versus long stock positions, 38 credit default swaps (CDS), 121 D deep in-the-money (DITM) options, , 229 delta,

18 Index 253 derivatives markets, Nobel Prize in Economic Sciences, 1997, 227 distribution of price change behavior, DITM (deep in-the-money) options, , 229 diversification versus hedging, dollar index U.S. dollar strength, versus SPDR Trust February 2006 through November 2009, July through December 2009, 13 March through December 2009, 17 November 27, 2009, 15 September 2003 through December 2004, 18 dot-com crash, 2000 new investment era, transformation after, Dow Jones Industrial Average January 1946 to January 2000, 125 January 1985 to January 2000, 130 January 2000 to June 2010, 130 September 1929 to July 1932, 119 Durable Goods Orders, 49 E economic reports/indicators, 3, adjustments, importance of, inaccuracies, 51 misleading, risks avoiding, 3 bonds, misconceptions, siding with government, efficient market hypothesis (EMH), 234 electronic marketplace high-frequency trading, short-term trends, technical trends, EMH (efficient market hypothesis), 234 Employment Situation Report by BLS, adjustments, importance of, inaccuracies, 51 ETFs (exchange traded funds) double/triple longs and shorts, 20 energy sector, 84 ETNs (Exchange Traded Notes), F Fama, Eugene, 234 Federal Reserve chairman, 8-11 financial bubbles, financial indicators, 3, importance of, misleading, report adjustments, report inaccuracies, 51 risk avoidance, 3 siding with government, 59-62

19 254 Index G gamma, 239, GDP (gross domestic product), 5-6 Genentech, 127 General Motors (GM) bonds, 42 catastrophes as trends, forecasting collapse, 121 global market influences, 9 dollar index, GDP (gross domestic product), 5-6 Iraq and Afghanistan wars, 6 trade deficits, 7-8 Goldman Sachs securities fraud, 29-32, steel forecast, 76 Google inaccurate analyst predictions, value fluctuations, Greeks, Greenspan, Alan, 8 gross domestic product (GDP), 5-6 H hedging versus diversification, high-frequency trading, historical versus implied volatility, housing market collapse, pre- and post-crash fluctuations, Housing Starts, 49 Housing subcategory, CPI (Consumer Price Index), I IBM Apple Computer s switch to Intel processors, 26 covered calls, loans to customers, 27 price targets, 187 technical analysis, technology licensing business, 26 implied volatility skewed or volatility smile, smile versus term structure, versus historical volatility, in-the-money options, 229 instability in today s market, Intel, 26, 127 investors/investments better than forecast, 49 buying the dips, blame for fluctuations, 2 bonds, companies, critical information about, 2, companies, meaningful insights into, economic report adjustments, economic report inaccuracies, 51 economic reports/indicators, 3, 49-51, misleading, economic reports/indicators, siding with government, 59-62

20 Index 255 financial market interrelationships, 2 financial market movement, 1 individual stock fluctuations, 2 investment houses, 63-66, 69 institutional versus private, 156 large-cap stocks, long-term investments, paper losses, 36 percent of net worth invested by private investors, private versus institutional, 156 versus large investment houses, 63-66, 69 risk avoidance, 3 risk misconceptions, VC (venture capitalist) approach, 24 ipath S&P 500 VIX Mid-Term Futures ETN (VXZ), 172 ipath S&P 500 VIX Short-Term Futures ETN (VXX), 172 Iraq and Afghanistan wars, 6 J J.P. Morgan, Japan, financial bubbles, Jobless Claims, adjustments, importance of, inaccuracies, 51 K L Kerkorian, Kirk, 107 Khelil, Chakib, 86 leverage in today s market, liquidation preferences, 24 Livermore, Jesse, 124 lognormal distribution, long stock positions versus covered call positions, 38 Long-Term Capital Management (LTCM), long-term investments buying the dips, fallacy of, paper losses, 36 LTCM (Long-Term Capital Management), M N Malkiel, Burton, 233 Martin, David, 77 McDonalds, toy business, 28 Merton, Robert, 227 Microsoft, 127 Morgan Stanley, 77 naked calls and puts, NASDAQ market collapse in 2002 new investment era, transformation after, New Home Sales, 49 A New Method to Determine the Value of Derivatives, 227 news items catastrophes as trends, caution before actions, financial bubbles, financial news exaggerations, relevancy Amazon and Barnes & Noble, Amazon s Kindle ereader, 181 stock charts, 71-82

21 256 Index reversal predictions, stock charts fallacies, relevancy, news-annotated charts, 157 Nobel Prize in Economic Sciences 1997, 227 O oil trading caution before actions, Euro/dollar versus Brent crude oil, versus NYMEX light sweet crude oil, 95 financial bubbles, news items exaggerations, of relevancy, OPEC (Organization of Petroleum Exporting Countries), 85 option pricing, volatility. See volatility out-of-the-money puts or calls, 237 over fitting, 159 P Paulson, John, PE (price/earnings) ratio, 28, PPI (Producer Price Index), 49 price spikes, calculating odds of, price/earnings (PE) ratio, 28, private investors disadvantages against institutional investors, 156 versus large investment houses, 63-66, 69 Producer Price Index (PPI), 49 puts and calls, Amazon, July-August 2010, 197 cash-covered, 230 implied versus historical volatility, short at-the-money puts, Q R random number generation detecting, volatility versus, random walk concept, 233 A Random Walk Down Wall Street, 233 Research in Motion, 205 residential mortgage-backed securities (RMBS), 30 reversal predictions, rho, 239, 247 RMBS (residential mortgagebacked securities), 30 Roaring Twenties, Russia, Asian financial crisis, July 1997, 134 S S&P500, day exceeding threshold January 1995 and January 1999, 142 July 2008 and July 2010, Schmidt, Eric, 189

22 Index 257 Scholes, Myron, 226 SEC (Securities and Exchange Commission), Goldman Sachs suit, 29 seller aggressiveness, short at-the-money puts, skewed volatility or volatility smile, SPDR Trust ETF, June 6, 2010, 138 versus dollar index February 2006 through November 2009, July through December 2009, 13 March through December 2009, 17 November 27, 2009, 15 September 2003 through December 2004, 18 stagflation, 127 stock alternatives at-the-money covered calls, at-the-money puts, collars, covered calls, DITM (deep in-the-money) options, synthetic stock, vertical bull spreads, weekly options, stock charts catastrophes as trends, fallacies, in predictions, invalidating, 140 major resets, relevant news items, 69 Amazon and Barnes & Noble, Amazon s Kindle ereader, 181 caution before actions, exaggerations, financial bubbles, oil trading, reversal predictions, U.S. Steel, stock markets January 1946 to January 2000, 125 January 1985 to January 2000, 130 January 2000 to June 2010, 130 September 1929 crash post-crash fluctuations, , 124 to July 1932, 119 strike prices, 228, 230 Sun Microsystems, symptom of eventual collapse, 135 synthetic stock, T TD Securities, technical analysis, modern era, technical charting catastrophes as trends, fallacies, in predictions, invalidating, 140 major resets,

23 258 Index relevant news items, 69 Amazon and Barnes & Noble, Amazon s Kindle ereader, 181 caution before actions, exaggerations, financial bubbles, oil trading, reversal predictions, U.S. Steel, technical trends, term structure, theta, 239, tick-level chart, SPDR Trust ETF, June 6, 2010, 138 trends in randomly generated charts, 159 short-term, technical, U V U.S. dollar value dollar index, plunge, 6-9 strong dollar and weak markets, 9-10 U.S. Steel, VCs (venture capitalists), 24 vega, 239, 246 vertical bull spreads, VIX (Chicago Board Options Exchange Volatility Index), 155, 168, 217, 230 trading, VIX/true ratio, volatility, 155 calculating, ETNs (Exchange Traded Notes), implied versus historical, indexes, random number generation versus, volatility or skewed smile, volatility smile versus term structure, trading, Volatility Index. See VIX W Z Wagoner Jr., G. Richard, weekly stock options, World War II end until NASDAQ and dot-com crashes,